Matthews Asia Perspectives

The Case for Asia Credit Amid Rising Rates and Inflation

23 May 2017

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When it comes to enhancing portfolio yield and diversification, Asia offers compelling opportunities. But not all Asian markets are the same, and in some cases, cultural influences should be considered. Portfolio Managers Teresa Kong, CFA, and Satya Patel, explain how they navigate rising rates and inflation.

The Case for Asia Credit Amid Rising Rates and Inflation
When it comes to enhancing portfolio yield and diversification, Asia offers compelling opportunities.

The U.S. Federal Reserve has taken gradual steps toward what is known as policy normalization by raising the target range for its federal funds rate three times since late 2015. Europe—including the U.K.—is a bit behind. Yields remain low in developed markets, yet inflation is rising.

Amid this environment, how should fixed income investors preserve their portfolios and generate attractive income? We believe an allocation to Asia credit can inject yield into a broader fixed income portfolio while enhancing its diversification.

Traditionally, Asian interest rates have been closely correlated with the United States. When the U.S. economy heats up, it generally affects the rest of the world. Asia in recent times, however, has benefited from structural reforms at a time of higher political risk in developed markets.

It is also important to keep in mind that not all Asian markets are the same. Hong Kong is often highly correlated with the United States. Other markets, such as Thailand, are much less correlated and interest rates in frontier markets such as Vietnam, Sri Lanka and Pakistan are more affected by local factors such as inflation and fiscal policy.

Look East

But why look east when rising U.S. rates are bound to result in higher rates in Asia? Well, it depends on the type of Asian bond. As U.S. interest rates rise, local currency bonds will show correlation with interest rates. The biggest influence, however, is the interest rate differential between the local economy and the U.S. If rates rise substantially slower locally than in the U.S., there may be outflows back to the U.S.—the reverse of what is called the carry trade—and this may lead to depreciation of the local currency.

Asian companies also issue U.S. dollar-denominated debt and the interest-rate component will be linked directly to the U.S. In a thriving economy, as rates increase, credit spreads will tighten. As a result, there is less difference in yields between higher and lower quality bonds. In such an environment, however, the price sensitivity of U.S. dollar-denominated Asian bonds is considerably less affected than that of U.S.-dollar bonds such U.S. Treasuries.

Another reason Asia debt may present an attractive opportunity for investors: Asian companies that issue U.S. dollar-denominated debt tend to have solid fundamentals. Often, they represent blue chip companies within their countries and tend to have lower debt levels and better cash flows than their counterparts in developed markets. As bond valuations are less efficient among the emerging and frontier markets, active managers have more opportunities to generate alpha.

Within the high-yield asset class, Asia offers a superior risk return profile compared with the U.S., Europe and Latin America high yield. In addition, Asian bonds have historically had one of the lowest betas—i.e. price sensitivity—to U.S. Treasuries.

Monitoring Default Rates

A key determinant of how and where spreads will move is market default rates. Over the past cycle, most Asia credit defaults have been within commodities, such as oil or coal companies, as a result of falling prices. Prices have now stabilized and they need only remain at a level where the least-efficient producer can produce their goods at a profit in order to avoid default. As a result, we believe default rates have stabilized and might even fall.

Cultural influences also should be considered. Asia has many types of bankruptcy laws that do not have as many precedents as the U.S. bankruptcy code. This can make the
outcome of defaults less certain, as U.S. and U.K. law are based on precedent, whereas Asian ones tend to follow the letter of the legislation.

While there is no matrix for default outcomes, we have made a close study of Chinese defaults. China’s recovery rate has been very close to that of the U.S.—around 45 cents on the dollar. The average offers less comfort, however, as it tends to be all or nothing, and it depends on the structure of the default. One way to mitigate such risks is to consider using an active manager.

Our Process

At Matthews Asia, our strategy is based on careful credit analysis and a long-term approach for making investment decisions. We look for the persistence of the structural
components of the data and if consistent over quarters—or even years—investors can take advantage of the market fluctuations that can be sparked by the noise of the daily
news cycle.

As the search for yield continues and low but rising interest rates could possibly erode investors’ bond portfolios, our view is that Asia credit presents investors with a compelling investment opportunity.

Teresa Kong, CFA
Portfolio Manager
Matthews Asia

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